Fundraising

Flat is the new up

The startup ecosystem has a painful year ahead. Nearly half of Series C fundraising rounds were down or flat in 2016. Series B startups are next in line to feel the pain. [A] flat [round] is the new up [round]. If you really need another venture acronym, call it FITNU.

The market correction will not stop at Series B. If you’ve raised a Series A and need more capital in 2017, what I’m going to share might save your company. If you’re at the seed stage, this article might save you a lot of trouble.

Wait, what happened?

According to some investors, 2017 was supposed to be the turnaround year. Didn’t U.S. venture capital funds raise a record $42 billion in 2016? Didn’t we get past the notorious bubble?

Not quite. The bubble broke in 2015 when the tourist VCs driving unicorns in so-called private IPOs got spooked. They pulled back. This ratcheted down the VC food chain. The system couldn’t support the wild number of seed deals and high valuations. To protect itself, the system concentrated more money into fewer deals.

PitchBook found that the number of U.S. seed rounds declined 43 percent, from 1,537 deals in Q2 2015 to 872 in Q4 2016 — a four-year low. Early-stage financing (Series A and B) followed along. Deal volume tanked from 830 in Q2 2014 to 524 in Q4 2016.

Meanwhile, deal sizes swelled. Indeed, 42 percent of seed rounds were between $1 and $5 million in 2016, the highest proportion PitchBook has recorded over the past 10 years. Almost 50 percent of the early-stage money went into rounds worth $25 million or more in 2016.

Corroborating PitchBook, Redpoint Venture’s Tomasz Tunguz points out that the median seed round tripled, from $272,000 to $750,000 between 2010 and 2016. His analysis of Crunchbase data also shows that the median A round climbed from $3 million to $6.6 million over the same span, and the median B leapt from $10 million to $15 million.

So why the flat rounds?

In the bubble, more startups received seed funding because so many new seed venture firms entered the business. But the number of Series A firms didn’t grow much at all — they just raised bigger funds. Thus, Series A firms started writing bigger checks to meet the needs of their business.

Unfortunately, few seed startups qualify for $10 million to $20 million “Super-Sized” A rounds. As a result, the seed-to-A graduation rate plummeted. Series A follow-on investments dropped from roughly 25 percent in 2012 to less than 10 percent as of midway through 2016, says PitchBook. Over time, a lot of the seed-funded companies get extensions, so the graduation rate is probably closer to 20 percent. This is well below what it used to be, at 45-50 percent.

Plenty of companies took premature, massive A rounds and guzzled capital all the way to Series B. They became the source for all those flat and down C rounds. As I said, nearly half of C rounds were down or flat in Q3 2016.

Let me illustrate why. At the Series A, let’s say an investor buys 25 to 30 percent of a company and puts in $10 million. That defines the value as $33 million to $40 million post-money. B-round investors want to see at least a twofold increase from the post-money A to pre-money B. If not, they calculate they’re better off waiting for the C round.

In bubbly conditions, getting the 2x increase in valuation was easy. Startups hit their B. Then the market correction began, so they went flat or down at C. The flat and down rounds will sweep down from Series C to B to A to seed. In other words, winter isn’t over, Mark Suster.

Reseeding

In 2017, Series A companies will struggle to get their pre-money valuation high enough for the B round. If you take a flat or down round, it’s time to “reseed.” Effectively, you need to cut costs until your company resembles a post-seed startup.

Many founders think it’s “death” to take a flat or down round. They believe that partly because of equity dilution and partly because of signaling.

No company ever went bankrupt because of dilution. The real signal is what a company looks like after a flat or down round. Did it restructure to match the new reality? If so, it’s a more attractive company. The down round isn’t the problem as long as the company adopted a leaner, more sustainable model.

The capital structure is the hardest issue to solve because there can end up being too much preference from the Series A. Imagine you do a $2 million seed, and the investor has $2 million of preferred stock. Then you raise a $10 million Series A, and the A-round firm has $10 million in preference. You have a total $12 million in preference with a debt component that has to be paid back.

Sane investors don’t want $12 million in preference ahead of them at post-seed values. Even worse is getting the B round and having to reseed. You now have to deal with $25 million or more in preference. Take care of it. Do whatever it takes to reduce preferred stock in the capital structure when you reseed. That’s a harder problem to solve than your burn rate.

Next to bat

“Flat is the new up” is one way to describe the post-bubble correction. Star companies of 2014 and 2015 took flat or down rounds for their Series C. Startups that raised, say, a $1 million seed and $10 million Series A are now going through it at the Series B. Many will reduce employees and restructure their cap tables until they resemble post-seed companies. Reseeding is better than going down in flames. And, paradoxically perhaps, you might find that you grow faster with fewer employees and less internal contention. Maybe the premature Big A wasn’t such a good idea after all.

The 12 Best Places in America to Raise Money

A new study from Pitchbook crunches 10 years of numbers to paint a clear picture of how access to venture capital is different across the country. This info is far from academic. For entrepreneurial Millennials, today America’s largest working generation, thinking about where to settle down often also includes thinking about where to launch a startup, someday. For city leaders, organic tech jobs are dependent on the startup economy. For founders intent on surviving the venture capital downturn, this report also offers great perspective on regional nuances in startup finance.

For those cities bringing up the rear, he encourages that improvement in ranking, “comes down to fostering a supportive ecosystem of local investment firms” and keeping an eye on other factors like cost of living.

The top cities for raising money.

1. San Francisco came in at number 1, with$117 billion in funds raised since 2006 and 9710 deals in the same time period.

2. San Jose, at $35.5 billion in venture funds raised since 2006.

Together, these two California cities are the juggernaut of startup finance. The last full year of data, 2015, showed 664 active venture funds in San Francisco alone. To compare it to the city last on the list, Atlanta, there were 28 active local funds last year. Looking at the difference in venture firm population, it puts it in perspective that Atlanta raised $1.15 billion since 2006, and San Francisco one hundred times more, $117 billion.

But despite the sheer scale differences between the first and last city in this venture ecosystem report, it’s not all roses in Silicon Valley. Black points out, “the Bay Area still holds the title in terms of sheer concentration of activity, but the interesting thing to note is the rate of growth elsewhere. Seattle, for example, saw overall number of venture rounds double between 2010 and 2015, while Philly saw its first-time financings double in the same timeframe.” In addition, the research reveals that top regions like San Jose and San Francisco are seeing a slowdown in terms of first financings. Now jumping to the East Coast:

3. New York, $43.6 billion in venture funds raised since 2006

4. Boston, $41.2 billion in venture funds raised since 2006.

Yet the East Coast exits are taking their time. “New York, for example, has had $33.9 billion invested into companies headquartered in its MSA since 2010, while the amount exited during the same time period has only amounted to $17.6 billion, almost half the value,” says Black.

Good cities for raising money

5. Los Angeles, $2.6 billion raised since 2006. While the MSA is significantly less active in raising capital, Pitchbook placed them high on the list in part due to their $11.2 billion in exits since 2010.

6. Seattle, $7.6 billion raised since 2006

On the list at #7 appears our first non-coastal city:

7. Chicago, $3.4 billion raised since 2006

8. Washington, DC, $4.8 billion raised since 2006

Emerging cities for raising money

9. San Diego, $1.5 billion of funds raised that is attracting $9.4 billion of funds invested since 2006

10. Austin, another non-coastal city, at $1.9 billion in funds raised spread across 1375 first financings in this period–one of the best dollar to dealflow ratios on the list.

11. Philadelphia, with $3 billion in local funds raised serving 1003 local deals in the time period.

12. Atlanta, with $1.15 billion in funds raised since 2006 and 867 local deals in that time period.

Local venture firms sway startups to stay

Black noted trends that suggest the venture capital frontier is no longer the West Coast, even as the area remains the ecosystem’s finance hub. “Areas like Austin and Philly have been receiving more attention from outside investors over the last few years, which could indicate that investors are looking outside of the traditional startup hubs for quality investments,” he says.

For cities that would like to attract more startups, Pitchbook’s report indicates it’s a balancing act for founders, between their actual access to local venture capital and their costs of living. “Generally speaking, the ratios of outside and inside investors was surprising. The vast majority of funding in each region came from outside investors,” says Black.

All cities in the report, from San Francisco to Atlanta, attract more venture capital from outside their city than from inside. Thus, attracting outside capital is not a core point in creating a strong venture ecosystem–it’s more of a symptom. The number of local venture firms plays catalyst in creating the startup’s opportunity to stay local. “If founders can access sufficient capital within their home towns that have equivalently friendly business climates among other factors,” Black points out, “then there is a compelling case to stay local.” See the full report.

Over the last decade, the early-stage funding environment has dramatically changed. There are now myriad financing options that founders can consider as they look to build their companies. Nearly 70,000 companies received funding through angel networks and 3,000 through venture capital firms annually, according to CB Insights.

On the most recent episode of Ventured, we spoke with Qasar Younis, Chief Operating Officer of Y Combinator (YC), about the early-stage funding landscape and how entrepreneurs can best navigate the waters of raising capital today. Here are some takeaways from our discussion.

Benefit from more accessible investors

The startup ecosystem is more sophisticated than ever before because of global availability to startup resources and new types of funding sources. With platforms like AngelList and Indiegogo, access to early capital has dramatically improved. Investors like Y Combinator (YC) and KPCB have continued to increase funding accessibility for founders regardless of location. Programs such as KPCB Fellows or KPCB Edge target entrepreneurs earlier in their careers while the YC Fellows Program and the YC College Tour seek to educate new entrepreneurs on how they can begin their journeys as founders.

Consider all funding options before tapping VCs

There are roughly four ways to get funding for your startup. Understanding your funding options and thinking critically about each path is crucial to your success — and is often overlooked.

Bootstrapping:This is how the majority of companies are funded today. The benefits here are that you retain maximum ownership of your company. However, this may not be sustainable as your capital requirements grow.

Incubators & Accelerators: If you are a first-time entrepreneur, it can oftentimes be helpful to join an incubator or accelerator to get your business going. While there’s a variety of these that exist today, most usually provide mentoring, content and a small amount of capital.

Online Platforms:There are a number of funding platforms available online. As a founder you can utilize these to get a sense of demand for your product, find angel investors from across the globe and get feedback on your company.

Venture Capital:While some founders may jump straight to venture capitalists, most usually reach this step later in the life of their companies. By utilizing the options, or a combination of options outlined above, you can prove more out as a founder prior to meeting investors.

Don’t worry too much about today’s macro environment

While the current economic environment has been fluctuating over concerns of global growth and European solidarity, early-stage founders should not panic. The macro-funding environment does not necessarily constitute a barrier to achieving success. Oftentimes, downturns provide unique opportunities for entrepreneurs to succeed because it’s harder for competitors to raise capital, and talent is usually cheaper to hire. For instance, more than half of the companies on the Fortune 500 list in 2009 were started during recessions or bear markets, as well as almost half of the firms on the Inc. list of America’s fastest-growing companies in 2008. In the most recent economic turmoil of 2009, both WhatsApp and Square were started.

Great companies are founded irrespective of a boom or bust. Startups are a test of will and determination and as a result are often on a seven- to 10-year time horizon, if not longer.

Stay focused on customers and users

While many entrepreneurs don’t realize it, they may be going through the motions and simply doing things that look and feel like work but aren’t actually creating value that will ensure long-term success. Two areas that highlight this gap are customers and product fit, or making stuff that people really want. Not enough entrepreneurs truly understand their customers, especially in the early days, even though that understanding will help dictate product and roadmap decisions. Similarly, founders need to be able to explain why customers actually want the product they are creating, since that insight will help drive almost any business forward.

Know that VCs invest in people, not pitch decks

Although we evaluate certain metrics that help us gain conviction about a particular company, we often invest in the intangibles — the things that are hard to get across on paper. We find ourselves asking questions like how do the founders work with each other, how do they communicate, what do they know that no one else knows and how are they uniquely positioned to solve this unique problem? Having conviction about the team beyond quantifiable growth or user metrics is a major driver for how we decide to invest in companies.

The purpose of a business—any business—is to generate shareholder wealth. A lot of businesses aim to raise capital during their various initial phases. It’s tempting to try and get funding in the beginning, while your ideas are still forming. Getting a lump sum of cash at the beginning could cost you: a big chunk of the company, board seats, and/or control. Instead, why not focus on steadily earning revenue while keeping the company your company?

Many entrepreneurs fall into the trap of raising capital because they’ve been told this is where to start. So how can you have a successful company without resorting to venture capital? Entrepreneurs should follow these few steps to maintain autonomous control of their companies.

Venture capital funds raised more money and more funds held closings in the first six months of this year than in any first half in at least six years.

The total raised was $17.35 billion, a 53% increase over the first half of 2013, according to Dow Jones LP Source. Early-stage funds helped increase the number of funds closed, but the bulk of the money went to late-stage and multistage funds.